Saturday, January 30, 2010

Given that I call myself The Raging Capitalist, I can't miss an opportunity to provide a good example of what the capitalist spirit is really all about. Such is provided in the linked article by David Brooks, particularly in his discussion of Lincoln and Hamilton. Brooks writes:

They rejected the zero-sum mentality that is at the heart of populism, the belief that economics is a struggle over finite spoils. Instead, they believed in a united national economy — one interlocking system of labor, trade and investment.

In their view, government’s role was not to side with one faction or to wage class war. It was to rouse the energy and industry of people at all levels. It was to enhance competition and make it fair — to make sure that no group, high or low, is able to erect barriers that would deprive Americans of an open field and a fair chance. Theirs was a philosophy that celebrated development, mobility and work, wherever those things might be generated.

Brooks' concern is that populist rage over abuse of the financial system will ultimately lead to the suppression of the capitalist ideals that have been so fundamental to our prosperity as a nation. His concern is valid, and the public's rage needs to be properly addressed, and without focusing that rage on a condemnation of capitalism itself.

Capitalists in no way want to turn a blind eye to those who have corrupted and co-opted our financial system. True capitalists aren't about gaming the system, or buying political influence, or hoodwinking the masses. They believe in the rule of law, creating open and fair playing fields, and allowing funds to easily flow between investors and entrepreneurs. Therefore, it would be high on the typical capitalist's agenda to want to dispense justice to those who have abused the financial system. However, those efforts need to be intelligently targeted and the penalties should be in proportion to the crimes (see my post on Obama's financial crisis fee). Similarly, we must enhance regulation, but we must take care to not strangle the system. We must ensure that risks taken with capital are in-line with investors' intentions, but capital must be allowed to flow freely. We must give the public free and fair access to the resources of the financial system, but we must not do it in such a way that checks and balances are ignored and unintended consequences result.

Importantly, we must remember that capitalism is a system. It has no political or social agenda. It doesn't think, or feel, or have opinions -- no different from the plumbing in your house. Attempts to weave the social agenda into capitalism (e.g., to make housing "affordable") have always failed, as they interfere with the "laws of nature" that apply to capitalism, such as having to live with the risks that you create. It is implicit in the capitalist system that its "users" -- the public -- can decide for themselves how hard they want to work, and how much risk they want to take. Some will succeed, and some will fail. Like Mother Nature herself, capitalism turns a blind eye to personal tragedy and hardship. Some will go out on a limb and run their own businesses, and others will choose to become human resources in those businesses. Capitalism makes no value judgments. Businesses generate profits, and their owners evolve into investors who bankroll the next generation of entrepreneurs. That's the cycle. That's how the system works. For all its harsh realities, capitalism is simple, self-correcting (when not interfered with), elegantly pure, and time-tested. We need to protect it with everything we've got.

Thursday, January 14, 2010

President Obama announced plans today to levy a “Financial Crisis Responsibility Fee” on the nation’s largest banks — those with more than $50 billion in assets. Basically, it will be computed as .15% (i.e., 15/100ths of 1%) of the banks’ liabilities, excluding deposits covered by FDIC insurance (because a separate fee is assessed on them).

To a revenge-starved public, this may sound SO right and be SO overdue, but it is SO wrong. Once again, Obama has proposed a solution — as he did with health care reform — that is so lacking in nuance that it is clear that he doesn’t truly understand the problem. Either that, or it’s simply more evidence that he’s in Goldman Sachs’ hip pocket.

So, what’s wrong with this solution? Answer: it penalizes conservative, well run institutions, and once again, lets those who are the real troublemakers off the hook. The troublemakers that are left alive, that is. Keep in mind that most of the institutions that caused the crisis are now out of business or were merged into more responsible firms and are now under new management. By far, the biggest culprit still standing — and thriving, as no financial reforms have yet been implemented — is Goldman Sachs.

Although Obama and the media refer to “banks” as a homogeneous group, it is important to separate routine commercial and consumer lenders from super-large “money center banks” (e.g., Citibank, BofA, Wells Fargo, and JP Morgan Chase) and Wall Street “investment banks,” the latter of which (e.g., Goldman Sachs) were not actually banks at all until the financial bailout. Although they’re called investment banks, they never had bank charters, weren’t regulated as banks, and didn’t have FDIC-insured deposits until Treasury Secretary Hank Paulson allowed them to convert into chartered banks in order for them to qualify for TARP bailout funds. It was a slight of hand to do a solid for his friends on Wall Street, plain and simple. The investment banks are the firms that engage in the most risky trading and derivatives activities, and such activities constitute a huge percentage of their overall businesses. Money center banks also engage in risky investment banking activities — “thanks” (I say facetiously) to the Clinton administration’s successful efforts to repeal the Glass-Steagall Act — but because they are so large and diversified in their activities, such risky activities are a much smaller percentage of their overall businesses. Even among the money center banks, however, some were much less careful than others in managing their risks: Citibank was perhaps the worst, and JP Morgan Chase seems to have been the best. Indeed, despite having a diversified portfolio of low-risk businesses, Citibank was nonetheless almost brought down by its relatively few higher risk businesses. (You remember the old saying about one bad apple, right?) Long story short, banks are very different from one another, and they need to be penalized based on the risks they take, not how big they are.

To illustrate the problem, I downloaded the September 30, 2009 financial statements for Goldman Sachs and a pretty “plain vanilla” large bank, U.S. Bancorp, from the Federal Reserve’s website. The financial statements show how much of the banks’ revenues come from routine banking activities versus high-risk trading operations, which are the “casino” activities that got us into so much trouble. Goldman’s assets as of September 30 were about 3.3 times greater than U.S. Bancorp’s, so I'll need to make some adjustments in my math for that. For the first 9 months of 2009, Goldman generated $28.3 billion of trading revenues and interest on trading assets. Essentially, rolling the dice, albeit, in a casino that they seem to have pretty much rigged most of the time, except for when things go terribly wrong. In comparison, U.S. Bancorp generated a paltry $125 million from trading. This is a staggering differential. Adjusting for the difference in the sizes of the two firms, for every dollar of assets deployed in their businesses, Goldman was conducting about 68 TIMES more casino activity. This helps put the difference in the nature of these two banks into some perspective. Relatively speaking, one is like a plodding old electric utility, whereas the other is a powder keg waiting to explode if any of its risk assumptions prove to be faulty, which is exactly what happened in 2008.

Recall, however, that Obama’s proposed fee will be based on liabilities exclusive of FDIC deposits. Granted, that helps equalize things just a bit, in that such deposits make up a much larger percentage of U.S. Bancorp’s liabilities. In other words, it will get a much larger exclusion from the fee than Goldman precisely because it is a more conservative institution, which is exactly what we want. Even so, however, when looking at casino activities for every dollar of liabilities to be taxed, Goldman is still conducting 25 TIMES more casino activity than U.S. Bancorp. Yet, they will both pay exactly the same fee on each dollar of assessed liability. Not exactly fair, is it? Relative to what it makes on high-risk activities, the fee/tax Goldman will pay will be insignificant.

Granted, I’m a financial professional, but it took me all of about 15 minutes to do this work. Importantly, though, I took the time to validate what I suspected intuitively. As I said in my second paragraph, solutions can sometimes seem so obvious and so clear, and yet be entirely wrong. This is an obvious trap to anyone who has ever done any serious analytical work, so trained professionals are always on the lookout for the biggest booby trap of all: things you think you know, but really don’t. That’s why solutions should be based on real analysis, conducted by bona fide professionals who know how to maintain their objectivity. As I have stated in previous articles, important decisions should not be based on hearsay, anecdotal evidence, or preconceived notions. Popular, but erroneous, decisions may sound good, but they don’t solve anything, they’re often unfair, and they often encourage the exact opposite behaviors of those we really want.

I know I sound like a broken record, but we simply need to demand a higher quality of work from our government.

U.S. National Debt Clock

About Me

Pat has nearly 30 years of experience as a financial executive. He is a CPA and holds an MBA from MIT's Sloan School of Management, where he was a Sloan Fellow. Pat's research interests include investments, financial markets, leadership and ethics, innovation and business sustainability, I.T. strategy, corporate governance, economics, politics, and globalization.